We commented on the ‘China sell-off’ in our previous Macro Matters: “Are there sharks in the water” on 28 August 2015.We see the risk aversion move as a correction rather than the start of a prolonged bear market for the moment. Hence we will be cautiously adding risk assets on dips.
Selling pressure and wobbly markets
Over the last few weeks there has been significant selling pressure from investors reducing equity exposure - the FT mentions that $128 billion has left US equity funds. Moreover, we believe that various systematic players have added to the selling pressures, for instance trend-following hedge funds (so- called CTAs) tend to sell assets once they have started to fall taking advantage of negative momentum which is likely to have exacerbated declines. In addition risk parity funds have been selling as the volatility of risk assets spiked.
As we type, markets remain very wobbly.There is uncertainty around the reasons behind the Federal Reserve (Fed) decision to keep rates on hold - Do they know more about the state of the Chinese economy than the market? - and the Volkswagen scandal didn’t help either. We commented on the `China sell-off’ in our previous Macro Matters. We see the risk aversion move as a correction rather than the start of a prolonged bear market for the moment. Hence we will be cautiously adding risk assets on dips.
What can we learn from the recent correction?
I believe it’s good practice to reflect on what has happened and what we can learn from it. From a tactical perspective we have done well. At the beginning of June we reduced our tactical equity exposure in anticipation of market volatility around an upcoming rate increase of the Federal Reserve (Fed). Our analysis shows that markets historically correct by about 8% around the time the Fed starts to hike rates. We believed this time could potentially be worse than the historical averages, as markets have been ‘addicted’ to zero rates for years and fixed income markets were not really pricing in imminent rate hikes.
Although the end of August correction was triggered by fears of weaker emerging market growth and not an increased probability of a rate hike, we see both as connected: it is not a coincidence that this emerging market driven correction happened while the wider markets were digesting a potential rate hike in the coming months. Investors fear that emerging markets in particular have everything to lose from higher rates in the US and a stronger dollar as it will make the emerging markets economies and currencies less attractive investments
However, tactical positioning is not the only pillar of risk taking in our funds. Strategic and medium-term positioning play an important part in our investment process and client outcomes as well. How we apply our risk budget over strategic (i.e. long-term), medium-term and tactical (i.e. shorter-term) horizons depends on the specific targets and restrictions of our clients and funds.
Our view on medium-term risk remained unchanged throughout the summer. We believe we are firmly ‘mid cycle’ in the global economy, with recession risk at very low levels. Our proprietary research shows that this is the sweet spot for risk assets.
Some people question how we match the two views, medium-term and tactical, which can at some points contradict each other. Would it have been better to sell more risk assets in the medium-term process in anticipation of a Fed hike? With hindsight the simple answer is obviously yes as we could have reduced an important drawdown for our clients by selling a lot more equities in June in light of our Fed outlook. However, irrespective of this we think it’s not the right process and it wouldn’t fit our clients’ expectations.
The risk around forecasts
Lars wrote in May’s Fundamentals “How Bulls Die” that just as important as correctly forecasting the end of a bull market is avoiding prematurely forecasting it. Our macro mapping work shows that equities typically deliver the best risk-adjusted returns throughout the expansionary phases of the economic cycle, so ‘long equities’ should be the default position for the majority of the expansion.
Looking more closely at the period around the start of recessions, however, shows that equities tend to fall in anticipation of the recession. On average the peak in equities occurred about six months before the start of a recession.
This has several implications for investors. Assuming investors have imperfect timing skills for the start of a recession, it would be prudent to become more cautious on equities as the economic cycle progresses into its late cycle phase. It also suggests that while the economy remains in a mid-cycle environment and recession risk is deemed to be very low, it is important not to get too stressed about things that are unlikely to change one’s view of the cycle. At any given time there is a long list of things investors could worry about.
In our reflection of what we could learn from the recent past we went back to re-read the minutes of our investment meetings over the past two and a half years and noted the things that we and the markets have anxiously discussed during that time. The figure below shows plenty of ‘events’ like the US debt ceiling or the Russian Crimea invasion that might look like trivial events now but looked like serious potential ‘risk-off’ events at the time.
The reason why these look trivial now is because they caused little market reaction: the chart below shows various events and how the bigger cycle dominated these shorter-term scares.
Timing is everything
When the economy is mid cycle and recession risk is low, the risk of the bull market ending and a bear market drawdown is equally low. Most events in that situation cause a relatively small and very difficult to trade correction – typically 5-10% – seen on average three times a year.
Our analysis shows that an investor with perfect timing skills would have been able to generate around 8% of performance by selling at the peak and buying back at the trough of these corrections. But assuming imperfect timing skills, missing the peak and trough by only four days would have reduced the gains to less than 3%.
It does not take much to end up destroying value.
With the benefit of hindsight it is easy to say that none of these had a material impact on equities, but it is more difficult to decide in real time how material a specific risk is. None of these factors should have been ignored but, when the economy is mid cycle and recession risk is low, we should be more relaxed about the constant stream of risks discussed by markets than when the economy is in a late cycle stage and therefore the bull market is more vulnerable. In each case we should ask the question:
If the answer is ‘no’ or ‘low’ then our positive mid-cycle view should prevail.
How we use this
We believe in absolute clarity around how and where we take our risk. For the different funds we take risks over a different time horizon to try and reach different objectives, as our clients expect us to. Our approach to medium-term risk taking is driven by three key factors:
- the economic cycle
- valuations, and
- the probability of a systemic crisis
Focusing on these factors, in combination with the above analysis of how bull markets end, allows us to concentrate on what really matters, ignore the noise and benefit from the bull market that started in 2009. While our tactical view can go against this medium-term view and leads to tilts in our risk taking away from the medium-term view, the size of the tilts will depend on the specific fund.
Adapted from "Don't sweat the small stuff" Emiel van den Heiligenberg, Macro Matters. For those interested in the original piece, please click here.